WEALTH HEALTH: Remember how you felt five years ago

Sunday

Mar 16, 2014 at 12:01 AM

“We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore.” -- Mark Twain

Chuck JaffeFor The Patriot Ledger

Five years ago, investors were feeling hopeless, battered by the market and pained by their portfolios.

At the point where many were turning “learned helplessness” into an investment strategy, a funny thing happened.

A bull market began that continues today, and some experts believe it could have a few more years to run.

Five years ago, no one recognized the start of the bull market for what it would become.

That’s why today -- as the fifth anniversary means the pain of the financial crisis has officially been wiped off of five-year track records with the Standard & Poor’s 500 up about 25 percent annualized in that time – investors would be wise to remember what the felt before it started, as they were reeling from the index’s decline of 37 percent in 2008.

In that moment, investors were cowering, frozen and impotent. They had, indeed, learned helplessness.

This premise comes from the study of canine behavior. To keep it all simple, consider the tale of Pavlov's dog, where the dog responded positively when a signal was given with a positive stimulus. Ring the bell at dinnertime and the dog quickly associates the bell with dinner and starts salivating when the bell rings even when there’s no dinner on the table.

But a 37 percent drop in the market was hardly a positive stimulus.

And other studies on dogs focused on the negative. Remove the bell and the dinner and put the dog in a situation where there’s no reward with the stimulus, just pain or discomfort. Think of it like the warning collar on an electric fence, where the dog gets the jolt and moves away to avoid future shocks.

When the market is imploding, however, it would be like giving the dog no place to go, no way to get away from the negative stimulus.

Studies have shown that when the dog has no way to improve its situation, and it sees or feels the stimulus, it loses emotional control, stops responding and starts whimpering.

The theory applies to humans because people want some measure of control in order to feel emotionally stable.

The phenomenon explains why five years ago – as the market was turning the corner on the crisis – millions of investors had become disengaged, emotionally anxious and unable to determine who to trust. They avoided the market well into the recovery and some are still out today.

Fast-forward five years and the problem now may be that investors feel a renewed sense of control, the bull market having restored some courage.

But if you were feeling fearful back then and you’re feeling a bit greedy now, then you have labeled yourself as one of the “others” who legendary investor Warren Buffett was talking about when he said “Be fearful when others are greedy, and greedy when others are fearful.”

In short, the smart money has made its profits on you.

If you don’t want that to happen again, then those extremes should be your stimulus, if not to act, then to at least make sure your strategy is positioned for whatever might happen next.

“There is always uncertainty which accompanies investing,” said Dr. Richard Geist of the Institute on the Psychology of Investing. “The events that move markets are always the unexpected ones. And given we can never know what will happen next -- despite all the gurus who tell us otherwise -- we have to be careful not to pretend to master experience by simplifying it.”

The one thing investors can be certain of is that a five-year bull-market run does not cancel out business cycles. While you can find experts who believe the upturn can continue for three more years – and skeptics who think it could end as soon as next week – investors need to plan for both possibilities.

Too many investors plan only for what they see as the likely outcome, and their expectation is based entirely on what has happened recently.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com. CLICK to read more of his columns.
Most people try to play the game by guessing what will happen, and following experts who claim to know. The problem is that they cite the expert whose record they like – the one who made a warning in 2007 or the less-prevalent buyer from early 2009 – without recognizing that few people made both calls correctly; bragging rights were earned by just making one good call.

The better solution is to have a plan, one that helps an investor plot out what they will do the next time the market has them feeling either hopeful and hopeless, one that can be put into action regardless of what happens next on the market, whether the party continues or in case this is the last anniversary we celebrate for the start of this bull market.